A rollover distribution from a qualified plan may be used as a short-term loan.
The PPA ’06 allows tax-free charitable contributions out of traditional IRAs of up to $100,000 in 2007.
When liquidating assets, consideration should be given to the source of the funds and the order used.
This two-part article examines common strategies to enhance the value of defined-contribution retirement plans and distributions. Part I, in the May 2007 issue, identified the various types of qualified defined-contribution plans and applicable withdrawal restrictions. Part II, below, discusses various issues and strategies to consider when an account owner wishes to access assets invested in a qualified retirement account.
The taxpayer may find that certain of his or her retirement accounts can be used as a ready source of funds to meet short-term cashflow needs. A rollover (in contrast to a conversion) can be used to gain up to 60 days’ use of the funds.
A rollover occurs when a distribution is made from a qualified retirement plan to an employee and the amount received is reinvested in another retirement plan (frequently an IRA) within a statutory period. Normally, a rollover or conversion occurs when an account owner transfers retirement assets from one account to another (e.g., when changing jobs). A conversion (or a direct rollover) occurs when the entire amount in a taxpayer’s qualified retirement plan is transferred directly from the old plan (i.e., the distributing plan) to the new plan (i.e., a trustee-to-trustee transfer without the taxpayer receiving cash or other property).
A benefit of a conversion, when compared with a rollover, is that it is not subject to withholding, while a rollover is subject to mandatory 20% withholding.25 A benefit of a rollover, however, is that the taxpayer can effectively use the cash distribution as a short-term loan; a conversion cannot be so used, because the account owner never actually receives the assets. In a qualified rollover, the amount distributed to the taxpayer must be reinvested within 60 days. If only part of the distribution is reinvested within this period (i.e., a partial rollover), only that amount is eligible for rollover treatment. A distribution can be in the form of money or property. If in the form of property, it must be recontributed to a qualified retirement plan or traditional IRA to be eligible for rollover treatment.26
In deciding whether a rollover or conversion should be used, the key is whether the taxpayer is in need of short-term cash. If so, a rollover (i.e., cash distribution to the taxpayer followed by qualified reinvestment within 60 days) should be used. If cash is not needed, a conversion should be used, to avoid 20% withholding.
A taxpayer receiving a distribution from a qualified retirement plan can effectively use a rollover to borrow from the plan. Distributions can be reinvested in the distributing retirement plan (if it so permits) or in a traditional IRA (enabling deferral to continue). However, because 20% of the distribution is subject to mandatory withholding, the taxpayer will experience a temporary shortfall (from the time of the distribution to receipt of a tax refund). To determine the required contribution, the amount actually received by the taxpayer in the distribution must be grossed up to the full amount of the distribution (i.e., amount before 20% withholding).
One of the biggest limits to the rollover loan described above is that the participant has use of the money for no more than 60 days. If the taxpayer needs access to the funds for a longer period, his or her employer plan (e.g., Sec. 401(k) or 403(b) plan) may allow loans for up to limited amounts (e.g., the lesser of $50,000 or 50% of account accumulations). Because the loan proceeds are not taxed as income, the Sec. 72(t) early withdrawal penalty does not apply. Generally, no restrictions limit the use of the loan proceeds; however, a definite and limited repayment schedule is required. In contrast to a bank loan, the interest for the use of the loan proceeds is paid to the retirement account, thus benefiting the participant.
The Pension Protection Act of 2006 (PPA ’06) provides another distribution option for traditional IRAs. This provision can benefit both deductible traditional IRAs (basis equals zero) and nondeductible traditional IRAs (basis equals contributions made). This legislation allows a taxpayer to make charitable contributions out of traditional IRAs of up to $100,000 annually; any excess contributed over the taxpayer’s IRA basis is excluded from gross income.27 This provision applies for 2006 and 2007. Thus, a taxpayer who makes such a contribution will receive the following tax benefits:
Exclusion of realized gain under Sec. 408(d)(8)(A).
Amount contributed qualifies toward the required minimum distribution (RMD).
Although the primary beneficiaries of the PPA ’06 provisions are taxpayers with traditional IRAs, they also benefit those with Roth IRAs who have not yet satisfied the five-year holding period required for account earnings not to be taxed on distributions. For these taxpayers, earnings that otherwise would be taxed on a distribution to charity qualify for exclusion.
However, the amount excluded from gross income cannot be deducted as a charitable contribution under Sec. 170.
Example: Taxpayer T has his IRA trustee make a $100,000 qualified distribution to a charity in 2007. T’s basis in his IRA is $30,000; the account balance is $100,000. While T can exclude $70,000 from gross income, his charitable deduction is reduced from $100,000 to $30,000.
When investment assets are liquidated and converted to cash, consideration should always be given to the source of the funds, regardless of the taxpayer’s age. Which accounts should be spent first?
Tapping retirement plans and taxable investments is relevant only if cashflow from other sources cannot be generated to meet the taxpayer’s needs. For example, if income received from taxable sources (e.g., dividends, interest, RMDs, income from part-time work) is sufficient to meet a taxpayer’s cashflow needs, he or she can allow retirement plan and investment assets to continue to grow.
This is important, as it allows for the most tax-efficient result (i.e., to defer the income tax obligation for as long as possible). For distributions needed to fund an early retirement, the same question applies, but must be combined with the goal of avoiding or minimizing the 10% penalty.
In general, assets should be tapped from assets or accounts in the following order:
Taxable accounts (so that tax-deferred growth in qualified retirement plans can continue).
Sec. 457 plans (because no penalty applies once separated from employment).
Secs. 401(k) and 403(b) plans (because the age-55 separation rule may apply).
Traditional IRAs (taxpayer generally must be at least age 59½ to receive penalty-free withdrawals).
Roth IRAs (no RMD rules apply).
The fundamental reason for taking funds from taxable accounts first is that by prolonging withdrawals from qualified retirement accounts, the latter have additional time to grow tax-deferred.29 Further, by tapping taxable accounts first, only the gain (excess of amount realized over adjusted basis) is taxed, often at favorable capital gain rates of 15% or 5%.30 When withdrawing qualified retirement account assets, the amount received is generally subject to ordinary income tax rates, which are as high as 35% (excluding any relevant state income tax liability). Another reason to liquidate taxable assets first is particularly important if the taxpayer is under age 59½; if qualified retirement accounts are liquidated and one of the exceptions noted in Part I of this article is not available, the distribution could be subject to the normal ordinary income tax rate, and the Sec. 72(t) 10% early withdrawal penalty.
In certain circumstances, however, taxpayers should consider holding taxable accounts until after qualified retirement plans are depleted. For example, by following the ordering rules above and using funds held in taxable accounts, the income tax obligation associated with the liquidation of qualified retirement accounts may be shifted to the taxpayer’s beneficiaries. That is, when the beneficiaries receive distributions from inherited qualified plans, the receipts are fully subject to income tax, because no basis step-up is allowed for retirement plan assets transferred through an estate, under Sec. 1014(c). Alternatively, because the bases of taxable assets are stepped up at death, heirs are not taxed on pre-death unrealized gain, under Sec. 1014(a)(1). Thus, a wise approach would involve considering the tax consequences not only to the account owner, but to the beneficiaries as well. By examining the optimal tax effect on the entire family unit, a preferred route may be for the account owner to spend down assets held in his or her qualified retirement plans prior to using those invested in taxable accounts. In addition, the appreciation on taxable investments may be greater than that on the retirement plan investments.
Qualified Retirement Accounts
After a taxpayer’s taxable accounts have been depleted, various qualified retirement accounts may be available to fund cashflow needs. Deciding which accounts to draw down initially depends largely on the ability to access balances without penalty. Again, if distributions occur before age 59½ and the taxpayer owns a Sec. 457 account, distributions from that account can be received without penalty, as long as the taxpayer has separated from employment from the employer holding the account. The next source of funding should come from the taxpayer’s Secs. 401(k) and 403(b) plans. Under Sec. 72(t)(2)(A)(v), withdrawals from these accounts can be made free of the 10% penalty if the owner is at least age 55 and has separated from employment from the employer that sponsored the account.
Traditional vs. Roth IRA
The next source of funding would be from a traditional or a Roth IRA. If the taxpayer is not yet age 59½ (and, thus, does not qualify for an exception to the early withdrawal penalty), he or she would likely draw on the Roth IRA first, because the withdrawal is tax free to the extent of contributions made, under Sec. 408A(d)(4)(B). Only if the Roth IRA income is received before (1) age 59½ or (2) holding the account for more than five years is it subject to tax plus the 10% penalty (unless an exception applies).
If the taxpayer has reached age 59½ and is choosing between drawing from a traditional or a Roth IRA, the analysis is a bit more involved. Traditional deductible IRA withdrawals will be fully subject to tax. However, withdrawals are only partially subject to tax for a nondeductible traditional IRA (basis equals contributions made). Withdrawals from a Roth IRA will be tax free (assuming the holding-period rules are met). A taxpayer could take distributions from each account, to moderate his or her marginal tax rate (unless said rate already is 35%).
Alternatively, the taxpayer may wish to deplete the traditional IRA prior to withdrawing from the Roth IRA. This would allow the latter assets to grow tax free (as opposed to tax-deferred) much longer; further, the income tax on the traditional IRA distributions will be paid by the older generation, not by heirs. This will mitigate any potential estate tax exposure to the extent the income tax burden is placed on the older generation.
Nonetheless, at age 70½, the taxpayer must begin taking RMDs from a traditional IRA. If the RMD is sufficient to meet the taxpayer’s cashflow needs, he or she would be well-advised to allow the Roth IRA to continue to grow (Roth IRAs are not subject to RMDs). In this way, the amount potentially passing to the taxpayer’s beneficiaries tax free will grow; further, this asset will remain income tax free to those recipients. Some argue that a rationale for distributing traditional IRA funds before Roth IRA funds is based on the notion that if tax-deferred growth (traditional IRAs) is good, tax-free growth (Roth IRA) is better.31
Rollover to a Traditional IRA on Separation from Service
When changing jobs, switching careers or retiring, an individual must determine the treatment of his or her employer-sponsored retirement accounts. The basic choices are to roll over or convert the retirement plan assets to a traditional IRA, leave the assets in the employer’s retirement plan, roll them into a new employer’s plan or cash out some (or all) of the assets.
Cashing out the retirement plan account obviously provides quick access to the funds, and enhances the taxpayer’s liquidity position. However, the improved liquidity comes at a stiff price: 20% of the distribution will be withheld for Federal income taxes (an additional percentage may be withheld for state income taxes); the amount withheld may or may not be sufficient to cover the ordinary income tax on the distribution. Moreover, the Sec. 72(t) 10% early withdrawal penalty will apply if the account holder does not meet one of the exceptions. Generally, the penalty will be imposed if the taxpayer is under age 59½, or under age 55 if separated from service from a Sec. 401(a), 401(k) or 403(b) plan.
Unless severe cashflow needs exist, most financial planners would argue against cashing out a retirement plan on changing jobs. Instead, it may be preferable to roll over the proceeds into the new company’s retirement plan or into a traditional IRA. If the individual is approaching age 55 and wishes to retire early and begin taking withdrawals, he or she may wish to leave the balance with the old employer, if possible.
Holding in Employer’s Plan
It may be possible to leave the assets in the retirement plan, if the vested balance in the employee’s account exceeds $5,000, under Sec. 411(a)(11). Depending on an employer’s plan rules, balances in qualified retirement plans between $1,000 and $5,000 will be rolled over into a traditional IRA for the taxpayer under Sec. 401(a)(31)(B), unless he or she instructs the plan administrator to the contrary; balances under $1,000 will be cashed out, unless the taxpayer advises the plan administrator to do otherwise. On reaching age 55, withdrawals would be free of the 10% penalty.
Traditional IRA Rollover
However, if the plan assets were rolled over to a traditional IRA, they would be “trapped” and could not be withdrawn penalty-free (barring one of the 10% penalty exceptions) until the owner reaches age 59½. For a taxpayer with a Sec. 457 account, a rollover into an IRA may be inadvisable because of similar withdrawal restrictions. Distributions from a Sec. 457 plan avoid the 10% penalty if the taxpayer has separated from service with the employer. However, if the taxpayer is not yet age 59½ and rolls over his or her Sec. 457 balance into an IRA, any pre-age 59½ distributions (subject to the exceptions) are subject to the early withdrawal penalty. Caution is advised, because the assets will take on the character of the receiving plan. If the taxpayer is ready to retire and over age 59½, cashing out the entire balance is still not advisable, as the taxpayer would owe taxes on that amount. However, if the assets are rolled over into a traditional IRA, distributions and the associated taxes can be spread over time.
Rollover from Old to New Employer
Likewise, depending on an employer’s plan rules, a new employee may be able to roll over assets from a previous employer plan. An employee switching employers must have the cooperation of both employers to transfer accrued benefits; retirement plans are not always required to make distributions to departing employees or accept rollovers from other plans.
With both options—leaving the assets in the old retirement plan or rolling them into a new employer’s plan—retirement savings will continue to be tax-deferred, as they would be if rolled over to a traditional IRA. In addition, employer plans may allow employees to borrow against the assets, a feature not available with an IRA (except for the short-term opportunity under the 60-day provision). However, employer plans generally have fewer investment choices than do IRAs.
After leaving an employer, transferring plan assets to a traditional IRA may provide a wider array of investment options. In addition, consolidating retirement assets from various sources into a single traditional IRA simplifies managing those assets and may eliminate or reduce management fees. To avoid mandatory 20% Federal income tax withholding, the asset transfer should be via a direct rollover (i.e., conversion), with the employer transferring the plan assets directly to the IRA custodian.
No one strategy will best suit all taxpayers when leaving an employer. Nonetheless, generally, retirement plan assets should never be cashed out. But, if an employee separates from service after age 55 and wishes to retire, he or she should probably leave the assets in his or her employer’s plan, so that withdrawals can begin without incurring penalties. If the employee plans to retire or is at least age 59½, rolling over all of his or her assets into a single traditional IRA could make management easier (and possibly less costly). By opening an IRA, the investment options are practically unlimited, and any bureaucratic issues of the former employer would be left behind.32
If an employee plans to work past age 70½, he or she should not roll over assets into a traditional IRA, because the IRA will require minimum distributions beginning at age 70½. However, with employer plans, RMDs do not begin until the later of age 70½ or retirement from employment (except for certain owners).
Qualified retirement plans allow taxpayers to increase their wealth and thereby improve their lifestyle during retirement. Depending on the type of qualified retirement plan, wealth enhancement is achieved through deduction, exclusion or deferral treatment, or a combination of these. The exhibit summarizes the rules for taking distributions.
In providing for retirement, a taxpayer should consider the implications of both the funds available through qualified retirement plans and these available through taxable investments. Key advantages of taxable investments are portability (i.e., immediate availability) and the potential to qualify for favorable tax treatment for net capital gains and qualified dividends.
Distributions from qualified retirement plans generally can trigger either some form of immediate taxation or continued deferral treatment of earnings through either rollovers or conversions. For a Roth IRA, distributions can be tax free.
Distributions may be subject to penalties if early or late. The tax rate on “early” distributions is 10%, and on “late” distributions, 50%. Effective tax planning can eliminate, or at least reduce, the penalty on “early” distributions. In no circumstances should the penalty tax on “late” distributions ever be incurred.
For more information about this article, contact Dr. Maloney at firstname.lastname@example.org.